Diverse Asset Class Correlation and Leverage

By: Paul_L_Kasriel

Fund managers and investors have been puzzled why prices across a wide spectrum of assets moved together last week - namely, down. I think it has everything to do with delevering. What is bringing about delevering? When a fund owns assets that are going down in value for some fundamental reason, say mortgage-backed securities whose underlying collateral are defaulting subprime mortgages, and the fund is levered, its creditors start to make margin calls.

The fund, then, has to sell assets to raise cash. The fund might end up selling relatively high-quality and liquid assets in order to raise the maximum amount of cash quickly to meet its margin call. This puts downward pressure on the prices of assets not tainted by credit risk.

Now price volatility increases in asset classes unrelated to the originally troubled asset class. Many hedge funds engage in seemingly low-risk strategies that have commensurately low returns. In order to boost investor returns, these low-risk funds incur leverage. Many of these funds measure risk by the price volatility of their asset holdings. When there has been an extended period of low price volatility, risk is considered to be low.

Therefore, more leverage can be incurred. But when asset-price volatility starts to increase due to the sale of assets to meet margin calls by funds with tainted assets, funds with seemingly "good" assets are forced to delever because of the increased risk these hitherto low-risk funds now face. So, the low-risk funds end up selling "safe" assets in the process of delevering, thereby putting downward pressure on the prices of these "safe" assets.

Leverage is wonderful when asset prices are rising. It is a bear when asset prices start to retreat. It creates a vicious cycle. Both the sinners and the sacred get got in the undertow.

Derivatives and Risk: When the Cost Goes Down, More Gets "Produced"

In recent years there has been exponential growth in the financial derivatives markets. Financial engineers have been hard at work designing and introducing derivatives that will shift the risk of almost anything you can think of. Today (or perhaps more accurately, a couple of weeks ago) the cost of shifting risk through the use of derivatives is (was) considerably less expensive than it was twenty years ago.

Econ 101 says that when the cost of production of something goes down, the quantity demanded of that something goes up and more of that something gets produced. So, if the cost of risk- shifting goes down, more overall risk gets created in the global financial system. So, yes, the growth in financial derivatives has enabled investors (?) to shift risk. It also has encouraged an increase in overall risk to be taken in the financial system.

By Paul L. Kasriel
The Northern Trust Company
Economic Research Department - Daily Global Commentary

Copyright © 2007 Paul Kasriel
Paul joined the economic research unit of The Northern Trust Company in 1986 as Vice President and Economist, being named Senior Vice President and Director of Economic Research in 2000. His economic and interest rate forecasts are used both internally and by clients. The accuracy of the Economic Research Department's forecasts has consistently been highly-ranked in the Blue Chip survey of about 50 forecasters over the years. To that point, Paul received the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic forecast among the Blue Chip survey participants for the years 2002 through 2005.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.

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